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Pay Capital Gains Tax to Reduce Expense Ratio of Investment Portfolio
Old 02-09-2014, 01:51 PM   #1
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Pay Capital Gains Tax to Reduce Expense Ratio of Investment Portfolio

Hi:

I am trying to determine whether it makes sense for me to change mutual fund investments in after tax accounts from funds with expense ratios between .5 % to 1.0 % to similar style funds with expense ratios ranging from .05 % to .3 %?

I would have to pay long term capital gains tax at 15 percent. There would be some long term losses that would offset long term gains, but there would still be an overall long term gain.

So, how do I determine if it is in my long term interests to make these fund changes?

I checked FIRECalc and was surprised to learn that I could increase the overall success rate of my retirement plan by about 5 % by reducing my overall expense ratio from .6 % to .2 %.

Thanks for your insight.
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Old 02-09-2014, 02:05 PM   #2
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I have the exact same problem with some Fidelity funds I've owned for years. All are actively managed and have fees close to 1%.

As to whether it makes sense, you have to look at the cost you will incur in CG taxes, and the number of years you have remaining to invest in alternate index funds. If you are going to retire early, and have a number of years with no earned income and no social security, pension, or RMDs, you may be able to keep your AGI under $36,250 (single) or double that much if married, and pay zero federal taxes on the gains. So for me, I've decided to leave the investments alone until I can create that scenario for myself.

If the funds are generally doing well, and are not highly sector specific to where they completely throw off your desired AA, it may just make sense to leave them alone for now. Without knowing the specifics in your case, it's hard to give you any more concrete advice than that though.
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Old 02-09-2014, 02:48 PM   #3
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Quote:
Originally Posted by Ready View Post
If you are going to retire early, and have a number of years with no earned income and no social security, pension, or RMDs, you may be able to keep your AGI under $36,250 (single) or double that much if married, and pay zero federal taxes on the gains.
Actually these amounts are for taxable income (in 2013), not AGI. Your AGI can be higher by your exemptions plus your standard/itemized deduction.
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Old 02-09-2014, 04:02 PM   #4
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Originally Posted by FIRE'd@51 View Post
Actually these amounts are for taxable income (in 2013), not AGI. Your AGI can be higher by your exemptions plus your standard/itemized deduction.
Yes, my mistake, thank you. So with deductions your income could be even higher.
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Old 02-09-2014, 05:07 PM   #5
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If you think you can eventually pay 0% on them, it might make sense to leave them alone. If you're going to pay 15% anyway, it really doesn't matter if you take the tax hit now or later so you might as well get the lower fees now.

Don't forget that the 0% level of $36.2K (x2 if married) includes the cap gains, so if you have a lot of cap gains you're going to push some of them into 15% anyway. Plus you might want to use the room in the 15% bracket to do Roth conversions, which would leave you little or no room for 0% LT cap gains.
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Old 02-09-2014, 09:16 PM   #6
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The answer to your question depends on the assumptions you make. You might want try modeling this w/ Excel. Qualitiatively what happens is that when you sell the high ER funds and pay the CG taxes, you end up with less money to reinvest. When you compare that with just holding the high ER funds, you should find that it's a race that the low ER funds will eventually win but the time frame depends on the difference in ERs. You then need to decide if your time frame is longer than the breakeven point or not.

As an example (please check the math)
1) Basis 50. Current value 100. Gain is 50. 15% CG tax is 7.5 so you have
92.5 to reinvest. Assume that the new investments double to 185. New basis and also Gain is 92.5. 15% CG tax is 13.875 Net after tax is 171.125.

If instead you continue to hold the high ER funds:
2) Basis is 50. Current value 100. Assume that the old investments also
double in the same time frame to 200. Gain is 150 and CG tax is 22.5
so net after tax is 178.5 which is more than in 1) above. However since
the high ER funds cannot have a return that is the same as the low ER funds,
the net must actually be lower than shown here. How much lower depends
on the difference in ER and the time period considered since you will basically, with the low ER funds, gain so much / yr and will catch up in N yrs where N depends on the difference in ER (and perhaps also on the avg gain/yr). For short periods, it may not pay to switch. For longer periods, it may, depending on what your time frame is.
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Old 02-09-2014, 09:34 PM   #7
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The basic calc is how many years of lower expenses will it take to pay off the CG tax "expense" you would incur. If you want to get fancy, you can use a spreadsheet and figure out what the higher cost basis of the new low cost funds saves you whenever you decide to sell.

On the other hand, are you sure the current funds won't match the index funds? I'd be willing to give a good fund a chance to prove itself.
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